Comptroller Dugan Urges Less Pro-Cyclical Approach to Reserves

WASHINGTON — Comptroller of the Currency John C. Dugan said today that the current approach to determining the loan loss provision forces banks to build reserves when it is most difficult, and urged a more counter-cyclical approach that would allow provisions to be made earlier in the credit cycle, when times are good.

"Perversely, as the banking industry experienced a prolonged period of rising and record profits in the booming part of the economic cycle in the earlier part of this decade, the ratio of loan loss reserves to total loans went down, not up – even though there was broad recognition that the cycle would soon have to turn negative," Mr. Dugan said in a speech to the Institute of International Bankers.

"Conversely, when the turn finally did come, and the tidal wave of losses began hitting shore, banks have had to recognize losses through a sudden series of increased provisions to the loan loss reserve, which in turn has more than offset earnings and eaten into precious capital," he added. "Stated differently, rather than being counter-cyclical, loan loss provisioning has become decidedly pro-cyclical, magnifying the impact of the downturn."

Current accounting standards for loan loss provisioning, both here and abroad, are based on the so-called "incurred loss" model, Mr. Dugan said. Under this model, a bank can make a provision to the reserve only if it can document that a loss has been "incurred," which means that a loss is probable and can be reasonably estimated. The easiest way to document those conditions is to refer to historical loss rates and the bank’s own prior loss experience with the type of asset in question.

In a long period of benign economic conditions, it becomes difficult to use acceptable documentation, based on history and recent experience, to justify significant provisioning, and when bankers were unable to produce acceptable documentation, auditors began to lean on them to reduce provisions or even take the more extreme step of reducing reserves – so-called "negative provisioning."

The result, he said, was that the industry went into the current downturn without adequate reserves to absorb the wave of loan losses that are now being recognized.

"Given where we are in the credit cycle, and taking into account all the competing considerations, I think it’s high time to ask and answer some hard questions about loan loss provisioning," Comptroller Dugan said.

"We need to do a better job of telling banks and their auditors, both in the United States and elsewhere, the degree to which they are permitted to use non-historical, forward-looking judgmental factors to justify provisions to the loan loss reserve," he said. "We also need to clarify that the documentation requirements for doing so are not a case of ‘mission impossible.’ "

"While some may believe that this message is already out there, I can assure you that many banks and their auditors thought otherwise when we were at the height of the last credit cycle," he added.

In addition, disclosure of bank reserving methodology and practices should be made more robust. "If banks believe they need more flexibility to use their expert judgment to recognize losses in the credit cycle, then that judgment should be able to withstand the glare of investor scrutiny as an important check on the process," Comptroller Dugan said.

Mr. Dugan said that current regulatory rules, which limit the use of reserves in Tier 2 capital to 1.25 percent of risk-weighted assets, should be revised to remove disincentives to building reserves.

The Comptroller said changes to the incurred loss model itself may be needed. "I think there are particularly strong arguments for a more forward-looking ‘life of the loan’ or ‘expected loss’ concept, where permissible provisions would focus on losses expected over a more realistic time horizon, and would not be limited to losses incurred as of the balance sheet date, as under the current regime," Mr. Dugan said.

The Comptroller noted that a Financial Stability Forum working group, which he co-chairs along Commissioner Kathleen Casey of the Securities and Exchange Commission, is exploring a number of questions with respect to reserves, and expressed hope that the work of this group will help inform the work of standard setters, supervisors, and policymakers in this area.

Mr. Dugan also said that it should be recognized that provisions banks have made recently, while a drag on earnings, have not only offset current charge-offs, but have built reserves to substantially higher levels that will help with future loan problems.

"We ought to be talking about capital and reserves, and we ought to be recognizing the fact that, where quarterly losses are caused by reserve-building, that’s a net result that is positive, not negative. When a bank takes a loss to build a reserve, it is appropriately recognizing problems that they will see on the horizon, which is all to the good."